A Comprehensive Overview of Private Equity Investments: Strategies, Returns, and Exit Scenarios

Paul Johnstone

Case study – A startup called FinLabs raises $2 million.

Questions

What is the timeframe for private equity (PE) investors limited partner (LP) looking for a return on their investment?

The timeframe for a private equity investor to expect the return of their investment can vary widely and depends on the terms of the investment agreement. Typically, private equity investments are longer-term commitments, often ranging from 3 to 7 years or even longer. The specific timeframe should be outlined in the investment agreement and will depend on the startup’s growth and exit strategy. It’s important to discuss and clarify the expected holding period and exit strategy with the startup’s founders and other investors before making the investment.

What would they expect in return?

Private equity investors typically expect a financial return on their investment, which may come in several forms, including:

  1. Capital Appreciation: Investors anticipate that the value of their investment will increase over time. They aim to sell their stake in the company at a higher valuation than their initial investment.
  2. Dividends or Distributions: Some investments may provide periodic payments in the form of dividends or distributions. However, this depends on the startup’s profitability and dividend policy.
  3. Share of Profits: Private equity investors may negotiate a share of the company’s profits, which could be paid out periodically or upon exit.
  4. Exit Event: The primary way private equity investors realize returns is through an exit event, such as the sale of the company, an initial public offering (IPO), or a merger. They expect to receive their portion of the proceeds from the exit based on their ownership stake.

The specific terms and expectations can vary widely depending on the investment agreement and the negotiation between the investor and the startup founders. It’s essential for both parties to have a clear understanding of these terms before entering into the investment arrangement.

Let’s say a private equity firm invested 2 million into a new fintech startup at a pre-valuation of $8 million.

What would be a reasonable equity stake?

The equity stake that a private equity firm would receive in exchange for a $2 million investment in a fintech startup with a pre-money valuation of $8 million depends on the negotiated terms and the post-money valuation.

The equity stake can be calculated using the following formula:

Equity Stake (%) = (Investment Amount / Post-Money Valuation) * 100

In this case, the post-money valuation would be the pre-money valuation ($8 million) plus the investment amount ($2 million), which equals $10 million.

Equity Stake (%) = ($2,000,000 / $10,000,000) * 100 = 20%

So, a reasonable equity stake for the private equity firm in this scenario would be approximately 20%. However, the actual stake may vary based on negotiations, additional terms, and preferences of both the investor and the startup’s founders. It’s common for equity stakes in early-stage startups to range from 10% to 30% or more, depending on factors like the level of risk, the startup’s growth potential, and the investor’s involvement and added value.

What return would PE firm provide to their LP investors?

The return that a private equity (PE) firm provides to its limited partner (LP) investors depends on several factors, including the performance of the investments within the PE fund, the fund’s investment strategy, and the terms outlined in the fund’s partnership agreement. PE firms typically aim to generate returns for their LP investors through various means, including capital appreciation, dividends, and distributions.

Here are some common return metrics and considerations:

  1. Internal Rate of Return (IRR):
    IRR measures the annualized rate of return that LPs can expect to earn on their investments over the life of the fund. PE firms often target a specific IRR based on the fund’s strategy and risk profile.
  2. Multiple of Invested Capital (MOIC):
    MOIC represents how much the LPs will receive in relation to their initial investment. A MOIC of 2x means LPs will receive twice their invested capital.
  3. Distributions: PE funds return capital to LPs as investments within the fund are exited (e.g., through sales or IPOs). These distributions can occur throughout the fund’s life.
  4. Carried Interest:
    PE firms typically earn carried interest, which is a percentage of the profits generated by the fund. Carried interest is typically distributed to the PE firm’s partners.
  5. Hurdle Rates:
    Some funds may have hurdle rates, which are minimum required rates of return that must be achieved before the PE firm earns carried interest.
  6. Investment Duration:
    The duration of the investment can affect returns. PE investments are often longer-term, and LPs may not see returns until the fund’s investments mature.

It’s important to note that PE investments are illiquid, and LPs should be prepared for a longer investment horizon, often spanning several years. The specific return expectations can vary widely depending on the fund’s strategy (e.g., buyout, venture capital, distressed assets) and the economic conditions during the fund’s life. LPs should carefully review the fund’s offering documents and discuss return expectations with the PE firm before committing capital.

An example

Let’s walk through a simplified example of how a private equity (PE) fund might provide returns to its limited partner (LP) investors:

Scenario

  • A PE fund is established with a total capital commitment of $100 million from LP investors.
  • The fund has a 10-year lifespan.
  • The fund’s strategy is to invest in and grow technology startups.
  • The fund’s partnership agreement stipulates a preferred return of 8% and a 20% carried interest.

Investment

The PE fund makes an initial investment of $10 million in a fintech startup.

Over the Years

  1. After 5 years, the fintech startup is successfully sold for $20 million, resulting in a 2x multiple of invested capital (MOIC) for that investment.
  2. At the end of year 5, the PE fund distributes $14 million to the LPs, representing the return of their initial investment ($10 million) plus the preferred return of 8% per year for 5 years ($4 million).
  3. The remaining $6 million profit is shared between the LPs and the PE firm. The PE firm receives 20% of this profit as carried interest, which amounts to $1.2 million.

End of the Fund’s Life

  • Over the remaining 5 years, the PE fund makes additional investments, some of which perform well and others not as well. The fund continues to exit investments and distribute proceeds to LPs as opportunities arise.
  • The fund’s final returns to LPs will depend on the performance of all investments made during its 10-year life.

Summary

  • In this simplified example, the LP investors received their initial capital back plus an 8% preferred return.
  • The PE firm earned carried interest based on the profits generated from successful investments.
  • LPs will receive returns based on the MOIC of all fund investments over the fund’s lifespan.

Please note that this example is highly simplified for illustrative purposes, and real-life PE fund scenarios can involve a more complex portfolio of investments and structures. Additionally, returns can vary widely based on the success of individual investments and market conditions.

Let’s review an example where the company doesn’t go to IPO, but it grows 10x over the 5 years and raises a B round for further expansion into the international market.

Certainly, let’s consider an example where a technology startup experiences significant growth over five years but doesn’t go public (IPO). Instead, it raises more funds in a Series B round to support further expansion, particularly into international markets.

Initial Investment:

  • In year 1, a PE fund invests $5 million in a tech startup at a pre-money valuation of $20 million, acquiring a 25% equity stake.

Growth Over Five Years:

  • The startup experiences substantial growth and achieves a valuation of $200 million by year 5, which is a 10x increase in valuation.

Series B Funding Round:

  • In year 5, the startup decides to raise additional capital to support its international expansion plans.
  • They successfully raised $50 million in a Series B funding round at a post-money valuation of $250 million.

Equity Stake and Ownership Changes:

  • After the Series B round, the PE fund’s initial 25% equity stake is diluted due to the issuance of new shares to Series B investors.
  • The PE fund now holds, for example, a 20% equity stake in the company.

Returns and Exit Strategy:

  • The PE fund’s original $5 million investment has now grown in value to $50 million based on the 10x increase in the startup’s valuation.
  • However, the fund has not exited its investment yet as the startup didn’t go public or experience a full exit event.
  • The PE fund may continue to hold its stake and work with the startup to create more value or prepare for a potential exit in the future, which could be through an IPO, acquisition, or other means.

In this scenario, the startup achieves significant growth without going public, and the PE fund participates in the growth by maintaining its ownership stake and potentially providing guidance and support for international expansion. The exit strategy remains flexible, and the PE fund may choose to exit at a later stage when it believes it can achieve the desired return on its investment.

What if it gets to 10 years and at that point, the startup has gone for another raise, Series C, raising an additional hundred million dollars? Of course, there’s dilution, but at this point the fund PE needs to exit and retune LP investment.

If the startup reaches its 10-year mark and has successfully raised a Series C round of an additional $100 million, there will likely be further dilution for existing investors, including the PE fund. At this stage, the PE fund might be looking to exit its investment.

Here’s how the scenario might unfold:

10-Year Timeline:

  • Year 1: PE fund invests $5 million in the startup, acquiring a 25% equity stake.
  • Years 1-5: The startup experiences substantial growth and reaches a valuation of $200 million.
  • Year 5: The startup raises $50 million in a Series B round, with the PE fund’s equity stake being diluted (e.g., from 25% to 20%).
  • Years 5-10: The startup continues to grow and plans for a Series C funding round.

Series C Funding Round:

  • Year 10: The startup successfully raises an additional $100 million in a Series C round, further diluting existing investors, including the PE fund.

Exit Considerations:

  • At this point, the PE fund may decide it’s time to exit its investment, as it has reached its 10-year horizon, and its mission might be to realize returns for its limited partners (LPs).
  • Exit options could include seeking a buyer for its equity stake, negotiating with the company for a buyback of its shares, or exploring secondary sales of its equity to other investors.
  • The exit strategy may also depend on the company’s growth trajectory, profitability, and market conditions. If the company is performing well and the market is favorable, the PE fund might seek a higher valuation for its stake.

It’s important to note that exiting a private equity investment can be a complex process, and the specific strategy will depend on various factors, including the startup’s performance, market dynamics, and the preferences of the PE fund and its LPs. The fund may work with financial advisors and legal experts to navigate the exit and seek the best possible return for its investors.

Let’s say that the LPs want their money back by 10 years, but the private equity group decides that they want to hold on to the investment. But do they see a clear upside? What could be the strategy? And over the 10 years, how have the PE firms made their money?

If the LPs want their money back by the 10-year mark, but the private equity (PE) group sees significant upside potential in the investment and wishes to continue holding, there can be various strategies and ways for the PE firm to continue making money over the 10-year period:

  • Distributions from Profits:
    If the portfolio company generates profits, the PE firm can negotiate with the LPs to distribute a portion of these profits periodically, even before a full exit. This can provide LPs with some liquidity while allowing the PE firm to continue holding the investment.
  • Partial Exit:
    The PE firm might consider a partial exit by selling a portion of its stake to secondary buyers or other investors. This can provide some cash to the LPs without completely divesting from the investment.
  • Growth and Value Enhancement:
    The PE firm can actively work with the portfolio company to accelerate its growth and increase its value. This could involve strategic initiatives, operational improvements, and potential add-on acquisitions to boost the company’s performance.
  • IPO or Strategic Sale Preparation:
    If the PE firm believes that an initial public offering (IPO) or a strategic sale would yield a higher return in the future, they can prepare the company for such an exit event over the 10-year horizon. This may involve improving financials, governance, and market positioning.
  • Dividend Payments:
    If the portfolio company generates consistent cash flows, it may pay dividends to its shareholders, including the PE firm. These dividends can provide a source of income over the holding period.
  • Secondary Market Sales:
    The PE firm can explore selling its stake in the secondary market to other investors interested in acquiring a position in the company. The price would depend on the company’s performance and prospects.
  • Refinancing:
    Depending on the company’s financial health, the PE firm could explore refinancing options that provide cash to the LPs while allowing the PE firm to maintain its ownership stake.

It’s important to note that these strategies may vary depending on the specific terms of the investment agreement between the PE firm and the LPs. Open communication and alignment of interests between the PE firm and its LPs are crucial. The PE firm’s ability to continue making money over the 10-year period will depend on the success of its strategies and the performance of the portfolio company.

How would dividend payments work?

Dividend payments in the context of private equity investments work similarly to dividends in publicly traded companies, but they are typically less common and subject to negotiation and agreement between the private equity firm and the portfolio company. Here’s how dividend payments could work:

  • Profit Generation:
    The portfolio company generates profits through its operations. These profits are also known as earnings or net income.
  • Distribution Decision:
    The decision to pay dividends is made by the company’s board of directors, which includes representatives from the private equity firm and potentially other investors.
  • Dividend Declaration:
    When the board decides to distribute a portion of the profits as dividends, they declare a dividend. The dividend declaration includes the amount to be distributed per share and the record date (the date on which shareholders must be on the company’s books to receive the dividend).
  • Payment to Shareholders:
    On the payment date, the company distributes the dividend payments to the shareholders. These payments can be in the form of cash or additional shares of stock, depending on the agreement.
  • Shareholder Allocation:
    Each shareholder receives a dividend payment based on their ownership stake in the company. This means that the private equity firm and other investors receive dividends in proportion to their equity ownership.
  • Taxation:
    Dividend payments may have tax implications for shareholders. In some cases, dividends may be taxed at a different rate than other forms of income, such as capital gains. The tax treatment can vary by jurisdiction and the individual circumstances of the shareholders.
  • Use of Dividends:
    The recipients of dividends, including the private equity firm, can use the funds as they see fit. They may reinvest the dividends into the company, distribute them to their own investors (e.g., LPs in the private equity fund), or use them for other purposes.

It’s important to note that dividend payments are not guaranteed and depend on the company’s financial performance and the decision of the board of directors. In some cases, the company may choose to reinvest all profits into its growth rather than distributing dividends. The terms governing dividend payments are typically outlined in the investment agreement and can be negotiated between the private equity firm and the portfolio company.

Conclusion

The world of private equity investments is multifaceted and dynamic, encompassing a wide range of strategies, investment horizons, and return mechanisms. Here are some key takeaways from the points discussed:

  1. Investment Terms Vary:
    Private equity investments can take various forms, including equity stakes in startups, buyouts of established companies, and even debt investments. The specific terms, such as equity ownership percentages, exit strategies, and return expectations, can vary widely and are negotiated between the private equity firm and the investee.
  2. Exit Strategies:
    Private equity investments are typically made with a clear exit strategy in mind, whether it’s an initial public offering (IPO), sale to another company, or another form of exit. The choice of exit strategy depends on the objectives of both the private equity firm and the portfolio company.
  3. Return Mechanisms:
    Private equity investors seek returns through capital appreciation, dividends, distributions, profit-sharing, and carried interest. The specific return mechanisms depend on the investment structure and negotiated terms.
  4. Investment Horizon:
    Private equity investments often have longer time horizons, ranging from several years to a decade or more. It’s essential for both private equity firms and their investors (limited partners) to align on the expected holding period.
  5. Exit Flexibility:
    The ability to exit an investment can be influenced by market conditions, company performance, and other factors. Private equity firms may choose to hold onto investments longer if they see growth potential.
  6. Dividend Payments:
    Dividend payments are a means for private equity investors to receive returns from their portfolio companies. These payments are typically subject to board decisions, depend on company profits, and are distributed proportionally to ownership stakes.
  7. Tax Considerations:
    Private equity investors should be aware of the tax implications of their investments, including potential differences in taxation for dividends, capital gains, and other forms of income.

In summary, private equity investments are characterized by their flexibility, complexity, and potential for significant returns. Successful private equity firms combine financial expertise with strategic guidance to enhance the performance of their portfolio companies and ultimately achieve returns for their investors. Effective communication, thorough due diligence, and the ability to adapt to changing circumstances are vital elements of a successful private equity investment strategy.